Volume XLVII
June 1999
0022-1821
No. 2
I.
INTRODUCTION
* An earlier version formed part of my PhD dissertation at the University of East Anglia,
Norwich, UK. I would like to thank Bruce Lyons and Steve Davies for their valuable
suggestions. The paper also benefitted considerably from the comments of Lars-Hendrik
Roller, Bernard Sinclair-Desgagne, Mike Waterson, and two anonymous referees. All
remaining errors are mine.
t Author's affiliation: WZB, 10785 Berlin, Germany; and Department of Management,
Texas A&M University, College Station, TX 77843-4221, USA.
email: cmatraves@cgsb.tamu.edu,
O Blackwdl Publiihen Ltd. 1999. 108 Cowlcy Road. Oxford 0 X 4 UF. UK. and 3S0 Main Street. Maiden. MA 02148. USA.
169
170
CATHERINE MATRAVES
171
dE
du
the symmetric subgame perfect Cournot Nash equilibrium with free entry (n = S/N^ = E + a)
generates
172
CATHERINE MATRAVES
where M = money spent on outside goods; Uj > 1 = the quality of good k; and 6 the degree
of substitution between goods where if S = 1, the goods are perfect substitutes. Assume each
firm adopts a single technology and has a single product. Following Sutton [1991] as in
footnote 2, but using a slightly more restrictive functional form for E{u) = u' where y is the
cost (or alternatively, the effectiveness) of R&D in raising product quality (performance), the
subgame perfect zero profit equilibrium yields
For this example, the limiting level of concentration is determined by the values of y and 6.
Thus, for a given Q, a lower y implies higher concentration.
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"The value of a tells us the extent to which increases in R&D expenditure would increase
a deviant firm's market share. For the example in Footnote 3, a is a function of y and 6,
neither of which can be directly measured. Empirically, the value of a can be linked to the
R&D to sales ratio and the number of different technologies (which must be proxied).
' Inasmuch as there exist any economies of scope in R&D, then for a given market size, this
will shift up the lower bound to concentration.
* Advertising/R&D to sales ratios of 1% provide suitable empirical criteria for classifying
an industry as Type 1 or Type 2. Importantly, these data are used purely to give a 'broadbrush' distinction between those industries identified by the exogenous sunk cost model (e.g.
bread, salt) versus the endogenous sunk cost model (e.g., cars, soft drinks).
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CATHERINE MATRAVES
'Mean concentration for industries characterised by both intensive advertising and R&D
expenditure was 44% in the US and 40% in the EU market in 1987 (Lyons, Matraves and
Moffatt [1998]). Table VI shows that concentration is much lower in the pharmaceutical
industry: 26% for the US, 19% for the EU.
* Note that average concentration is substantially higher at the therapeutic class level. Cool,
Roller and Leieux [1998] estimated mean US concentration to be 46.3% in 1982, and also
showed that this was relatively stable between 1963-1982. However, this stability may mask
significant turbulence (changes in survivor market shares and new drug introductions).
Unfortunately, global market size and market share data were unobtainable by therapeutic
class. One example of turbulence, however, is in anti stomach ulcer drugs, where the exbestseller, Zantac, had a 42% global market share until its patent expired. The pioneer,
Tagamet, was introduced in 1977. Zantac was marketed globally in 1983 and became the
market leader by 1987; Zantac had fewer side effects than Tagamet, although Tagamet was
also considered very safe. Two other H2-blockers were introduced in the late 1980s and did
not overtake Zantac. In 1989, a new type of anti-ulcer drug, Losec (a proton pump inhibitor
rather than a H2 antagonist) was launched; by 1994, Losec's sales were $2.2 billion compared
to Zantac's $3.7 billion. It appears that the 'exclusivity period' is decreasing (Grabowski
and Vemon [1990]; also see PhRMA [1996], for more examples).
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Over the past decade, leading firms have been competing more and more
at a 'global' level. Moving out of their home markets, particularly
European firms entering the US in the 1980s, these firms produce and
market their products worldwide, though access to the Japanese market
remains relatively more difficult due to extensive non-tariff barriers
(Thomas [1996]).' Most of the world's Top 20 firms, with approximately
50% of global pharmaceutical sales and 85% of R&D expenditure, operate
in the key markets of North America, Europe and Japan (Grabowski and
Vemon [1994a]). The main driving forces of this globalisation trend are
outlined below.
First, competition is tougher due both to the emergence of new
technologies at the global level, and higher R&D costs. Even if the pricing
choice remains region specific, a firm's sunk cost decision may be taken
with the global market size in mind, depending on the transferability of
the sunk cost across borders (Davies and Rondi [1996]). Unlike advertising
expenditure, which is typically dependent on national culture, media and
language, the results for R&D are relatively easily transferable across
national borders. Once an innovation has been made, it can be exploited
'Pharmaceutical exports for all OECD countries increased from 23.5% of total production
in i982 to 28.5% in 1992. Sharp and Patel [1996] indicate the degree of self-sufficiency in the
key markets for 1991: Japan was the highest at 82% (German firms took 5%), the US with
70%, Germany with 52%, the UK with 35%. Three European countries have a significant
market share in the US market: UK firms with 15%, Swiss firms with 8%, and German firms
with 4.6%; US firms had a market share of 19% in Germany, 26% in the UK, and 21% in
France.
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'"indeed, our analysis of leading European pharmaceutical firms in 1993 strongly indicates
the importance of foreign markets. One example is Glaxo: sales by origin were 21% in the
UK, 21% in the rest of the EU, 44% in the US and 14% in the rest of the world (details of
other firms are available on request from the author). Ballance et al. [Ch. 3, 1992] also argue
foreign direct investment is more important in this industry than trade.
" In the US, the Food and Drug Administration (FDA) approves new drugs, where both
safety and efficacy must be shown; in Japan, safety only has to be proven, not efficacy. EU
requirements are generally not as tough as in the US (Dranove [1991]), and US approval costs
tend to be higher (Senker, Joly and Reinhard [1996]). Of the 154 drugs approved by the
FDA between 1990 and 1995, 103 (67%) were first approved outside the US (PhRMA [1996]).
In 1992, the Drug User Fee was passed which allowed the FDA to hire more reviewers to
speed up the approval process. In 1987, the mean review time was 32.4 months with 21 drugs
approved. This had decreased to 17.8 months by 1997 with 53 drugs approved. The statutory
standard is six months.
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TABLE 1
MARKET SIZE AT CURRENT PRICES (SBILLION)
Market Size
GER
FR
UK
EU
US
Japan
Global
1987
1988
1989
1990
1991
1992
1993
11.8
12.9
13.3
17.1
17.9
20.3
19.5
10.2
11.6
11.8
14.8
15.0
17.3
17.1
8.2
10.2
10.4
12.1
13.3
15.1
14.9
47.7
55.4
59.4
74.9
80.2
90.2
88.8
39.3
44.0
49.1
53.7
60.8
61.1
70.8
30.2
36.2
36.4
35.7
39.8
43.7
51.1
135.5
156.6
168.0
190.2
208.0
229.9
239.5
Source: These 'value of production' data are taken from the OECD 'Indtistrial Structure Statistics' and
account for ethical Pharmaceuticals only. The dollar conversion was made using the nominal average
exchange rate (OECD Outlook, June 1994).
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There has been a radical shift in the methodology by which new drugs
are discovered. The initial question arises whether this shift has affected
the underlying competitive mechanisms in the pharmaceutical industry.
Furthermore, the average real cost of introducing a new drug, which we
label the 'cost of innovation', has increased. The factors leading to this
increase are discussed, and the resulting predicted impact on the level of
concentration is derived.
Historically, the technologies by which most drugs were discovered can
be traced to random screening of thousands of compounds for efficacy
against a given disease, accidental discoveries, or incremental improvements to existing drugs (Schwartzman [1976]). Over the past two decades,
'random drug design' has been replaced by new technologies applying the
more focused 'rational drug design'. Due to major advances in basic
"Even if advertising/R&D expenditure decreases, in order for concentration not to rise,
it must be a significant decrease to offset the reduction in profits arising from tougher price
competition. The most likely outcome is an increase in concentration.
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'For example, Penan [1996] identifies 15 distinct research programs studying Alzheimer's
disease alone. These work through two main R&D technologies: neurotransmitter
augmentation and cognitive enhancing agents to slow down the neurodegenerative process.
Henderson and Cockburn [1996a] assert that leading firms typically invest in 10-15 different
research programs, where each program is targeted towards a particular disease area.
" Sutton [1996] uses the colour film market as an example of a Type 2 high-a industry
where during the shift from black and white to colour film, R&D expenditure escalated, and
merger/exit took place. Today, the global market is dominated by just five firms.
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181
TABLE II
NUMBER OF N C E S INTRODUCED BY COUNTRY OF ORIGIN
Country
1961-70
1971-80
1981-90
W. Europe
509
US
201
Japan
TOTAL
World Total
80
790
844
375
152
75
602
665
243
117
126
486
506
compared with larger firms who may be able to better diversify their
portfolio and absorb the risk of failure. Additionally, in order to recoup
R&D costs, extensive marketing is essential to launch the new drug
effectively, which works against small and mid-sized firms.
Let the fixed and sunk outlay required to achieve quality level, u, be
written as F(u) = 0 + E(u) where 0 = cost of innovation; E(u) = u' as in
our earlier example (footnote 3). An increase in the cost of innovation, <f),
is analogous to an increase in the exogenous overhead costs a firm would
pay upon entry into the market. It has no effect on y (the effectiveness of
R&D). It follows that it has no effect on the asymptotic level of
concentration as market size becomes very large. For any given market
size, however, concentration will increase (Sutton [1991, pp. 79-81]).
Under these conditions.
Prediction 3: As the cost of innovation <j) increases, the minimal level of
concentration for any given market size will increase.
Prescription Drugs versus OTC Products
Prescription drugs that offer a therapeutic advance have a first mover
advantage that tends to be overcome only if later entrants offer a distinct
therapeutic benefit, and not just a lower price (Bond and Lean [1977]).
Even once the patent has expired, pioneer products tend to keep a large
market share due mainly to prescribers' existing familiarity with the
product, and successful marketing (Caves, Whinston and Hurwitz [1991]).
Thus, entry is made difficult on the demand rather than the supply side,
through the stock of goodwill and prescribers' concerns over quality
differences. These effects are now somewhat weaker due to governmental
concern over rising costs forcing doctors to prescribe more cost-effectively
via generic substitution, the increasing importance of HMOs (in the US),
and better information (Grabowski and Vernon [1992]).
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^^ It used to be the case that for a generic introduction, many of the same trials had to be
replicated to prove safety and efficacy. This slowed down entry. Since this act was passed, a
firm only needs show bioequivalence.
^' In an advertising intensive industry, if the market is defined such that advertising covers
all a firm's products in that market, then this is equivalent to asstuning that the number of
technologies is one (a Type 2 high-a industry).
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EVIDENCE
^^ The example in footnote 2 can be easily generalised to two perceived quality enhancing
expenditures, , and Ej, where
In the limit, as S -> oo, [N + JV"' ] -* [2 + (y^/2(y -I- j8))] < [2 + (y/2)]. Consequently the limiting
level of concentration is higher with two types of endogenous sunk costs.
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TABLE III
UK AND US FIRM EXPENDITURE ON ADVERTISING AND R&D INDUSTRY (SMILLION)
UK R&D
UK R&D/S
US R&D
US R&D/S
UK Ads
UK Ads/S
1981
1983
1985
1987
1989
1991
1993
594.4
11.3
1866.2
8.3
66.2
1.3
572.7
11.7
2663.1
9.7
65.2
1.3
602.1
11.8
3370.7
10.7
65.5
1.3
1089.9
13.5
4503.2
11.5
111.1
1.7
1513.9
14.7
6019.3
12.3
130.9
1.5
2011.6
15.6
7923.6
13.0
155.2
1.4
2476.0
17.4
10473.0
14.8
166.7
1.4
Source: R&D/S = R&D to sales ratio; Ads/S = advertising to sales ratio; UK: Central Statistical Office
(CSO production data); Register-MEAL (Ads data); CSO Business Monitor MOM (R&D data); US:
OECD (production data); PhRMA (R&D data).
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TABLE IV
INTERNATIONAL COMPARISON OF FIRM ExPENDrruRE ON
R&D (%)
USA
Japan
Germany
France
Italy
UK
1983
1987
1992
10.6
6.7
8.4
7.1
7.6
11.7
10.6
7.5
9.6
8.4
6.3
13.5
14.3
9.8
9.2
8.7
8.1
16.3
"Ballance et al. [Ch. 7, 1992] state that the Ministry of Health and Welfare began to
remove entry restrictions in the 1980s. By 1990, foreign multinationals had a 15% share of the
domestic market. Japanese firms had relied on licensing agreements to sell their products
abroad, but are now beginning to invest abroad. FDI has been growing at 10% annually since
1989 (Scrip Yearbook [1995]). In 1992, Takeda's export sales were 10%, and Sankyo's were
8% of their total sales.
^'There are various market distortions: for example, France and Italy offer higher prices
if firms locate production in the country; even though Spain and the UK do not intervene in
price setting, a maximum level is set on the rate of return. In 1989, the Transparency Directive
was adopted; national authorities must clearly set out their pharmaceutical pricing procedures
(Klepper[1992]).
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TABLE V
Belgium
Denmark
France
Germany
Italy
NL
Spain
UK
100)
1981
1986
1988
1991
89
*
84
128
78
*
*
121
80
87
126
74
118
87
136
72
110
96
135
63
97
102
132
81
114
69
152
72
140
61
123
has, however, decreased over time (see also European Economy [1996,
p. 135]).^^
In the majority of the key markets, there have been attempts to reduce
healthcare costs. For example, prices were cut by 2.5% on reimbursable
drugs in 1993 in the UK, and the increase in fundholding doctors who
control their own budgets put extra pressure on prices. In Germany, the
government introduced a reference pricing system (where drugs are
grouped by therapeutic class) for the first time after reunification, and at
the beginning of 1993, there was a 5% cut on all prices not already
controlled. In Japan, at the beginning of 1993, there was an 8% price cut
on reimbursed drugs. In the US, the rapid growth of HMOs and the
increase in generic substitution has intensified price competition. Although
there continues to be substantial variation in the pricing systems for
reimbursed medicines across the industrialised nations, the evidence
suggests that prescribing doctors must be more accountable, and prescribed drugs more cost-effective. This supports the predicate Prediction 2
where if advertising/R&D expenditure increases and this is combined with
tougher price competition, then concentration must increase.
Predictions 2-4 therefore imply an increase in concentration.
Importantly, the 'correct' geographic market must be considered: if
competition is indeed taking place at the global level, then there should
not exist any systematic pattern at the national level. In other words,
concentration may increase or decrease at the national level, as firms
[1996] provides a cross-country comparison for 1992 weighted average prices
(at the manufacturers' price level); the drugs included are matched on the basis of molecular
content and therapeutic category. Constructing a Laspeyres index based on the price per
kilogram of the active ingredient (weighting by US quantity volumes) shows that prices are
higher in Japan and Switzerland than in the US (28% and 5% resp.), but are considerably
lower in France (43%), Italy (26%) and the UK (32%). Note these types of price comparisons
depend on the sample of drugs selected, the inclusion of generics, and the weighting scheme,
and moreover, are sensitive to the index used.
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TABLE VI
THE 4-FIRM CONCENTRATION RATIO BY THE VALUE OF PRODUCTION
Germany
CR4
UK
CR4
France
CR4
1987
1991
26
28
1986
1993
34
35
1985
1992
11
11
Italy
CR4
EU
CR4
USA
CR4
1987
1991
17
15
1987
1993
19
16
1979
1986
26
26
Note: The Japanese 1990 5-finn CR is 21.4% (Sharp and Patel, 1996).
Source: German and Italian data are derived from the firm size distributions (resp. by sales and
employment). UK and US (1986) data are derived from their Censuses of Production; French data were
provided by INSEE. Finally, the source for the 1979 US CR4 is IMS America, as reported in Cool, Roller
and Leieux (1998).
1985
1988
1989
1990
1993
1994
1995
1996
1997
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TABLE VIII
TOP 20 MARKET SHARES (%) WORLDWIDE: 1983-1995
Company
Glaxo Wellcome (UK)
Merck (US)
Hocchst Marion Roussel'
(Ger)
Bristol-Myers Squibb' (US)
American Home Products
(US)
Pfizer (US)
Johnson & Johnson (US)
Roche (Ch)
SmithKline Beecham' (UK)
Ciba-Geigy (Ch)
Rhone-Poulenc Rorer (Fr)
Bayer (Ger)
Eli Lilly (US)
Sandoz (Ch)
Schering-Plough (US)
Astra (Sweden)
Abbott (US)
Upjohn Pharmacia' (US/Sw)
Sankyo (Jap)
Takeda (Jap)
TOTAL SALES (Sbillion):
TOP 10 SHARE (%)
TOP 20 SHARE (%)
1995
Share
Rank
1992
Share Rank
1988
Share
Rank
1983
Share
Rank
4.5
3.5
3.5
1
2=
2=
3.8
3.6
2.6
1
2
4
2.7
3.2
2.5
2
1
3
1.2
3.1
2.5
17=
1
4
3.1
3.0
4
5
2.8
2.0
3
9=
1.6
2.1
12=
6
1.7
2.6
10=
2=
2.0
1.9
2.1
2.2
2.2
1.8
2.0
2.0
2.1
1.5
1.1
1.8
1.3
1.0
1.5
229.9
25.4
41.6
9=
13
7=
5=
2.9
2.9
2.6
2.5
2.5
2.2
2.1
2.0
1.9
1.9
1.8
1.8
1.7
1.6
1.6
250.0
31.0
49.6
6=
6=
8
9=
9=
11
12
13
14=
14=
16=
16=
18
19=
19=
14=
9=
9=
7=
16=
22=
14=
18
24
16=
1.6
12=
1.5 16=
1.5
16=
1.3 21 =
2.2
5
1.3 21 =
2.3
4
1.7
9=
7=
2.0
1.4
18=
Not Top 25
1.7
9=
1.4
18=
Not Top 25
2.0
7=
156.6
22.4
37.7
2.4
5
1.9
8
1.8
9
2.3
6
2.6
2=
1.1
19=
1.7
10=
2.1
7
1.7
10=
1.4
14
Not Top 25
1.0
21 =
1.3
15=
0.8
24
1.0
21 =
86.7
23.0
36.6
Source: Adapted from Financial Times, 25/3/96; Sharp and Patel, 1996; Ballance et al., 1992; Bogner,
Thomas and McGec, 1996. Total sales are derived from the OECD 'Industrial Structure Statistics'.
Notes: This Table shows the Top 20 for 1995 and how they ranked in 1992, 1988 and 1983.
a Wellcome: 1992=1.2; 1988 = 0.9; 1983 = 1; b Marion Merrell Dow: 1992 = 1.2; c Squibb: 1988 = 1.4;
1983 = 1.1; dBeecham: 1988 = 1.2; 1983 = 1.2; e Pharmacia: 1992 = 1.2.
189
Table IV clearly shows that R&D expenditure escalated from 1987, but
only recently has merger activity been substantial. In the UK, for example,
the number of world-class pharmaceutical firms was reduced from six to
three in 1995. Boots Pharmaceuticals was acquired by BASF, Fisons was
acquired by Rhone-Poulenc Rorer (RPR), and most importantly, Glaxo
and Wellcome merged (forming the world's largest pharmaceutical firm).
Although the firm-level company account evidence shows that it is
currently true that mid-sized firms can compete with the industry's leaders
in a limited line (e.g., Zeneca, UK), some of the recent merger activity,
as shown in Table VII, indicates that a mid-sized firm may be less able to
survive if it wants to be an innovator, (e.g., Fisons/RPR or Upjohn/
Pharmacia).^^ This is the impact of the cost of innovation effect as stated
in Prediction 3.
Table VIII shows the changes in the global market shares of the leading
twenty pharmaceutical firms between 1983 and 1995. Up until 1988,
market shares remained pretty stable although firms were changing rank.
Between 1988 and 1995, the global market shares of the Top 10 firms
increased from 25.4% to 31%, an increase of 5.6 percentage points in
concentration. This is a significant (z = 3.56) increase and also indicates
that given that market size increased over this time period, the largest
firms are growing more quickly than market size. Furthermore, the second
rank of firms (11th to 20th) gained market share, rising from 16.8% in
1992 to 18.6% in 1995." Overall, this significant increase in global
concentration is consistent with Predictions 2-4.
This section has shown that the data support our expectations. It is
interesting to ask, however, what the alternative hypothesis would be. It is
clear that the alternative is not that the pharmaceutical industry is a
Type 1 industry, as in such industries, firms compete in price only. Only
within the generic pharmaceutical sector where firms are commodity
producers, do firms compete in price. As market size increases, we would
^* Alternatively, it may be that due to the wide range of available technologies, the national
and EU data mask changes in therapeutic class concentration. In other words, concentration
could be increasing at the therapeutic class level but could still be decreasing overall if indeed
firms are specialising more. Firm level evidence (derived from company accounts) shows that
of the leading UK firms in 1993, for example, only Glaxo and SKB operated in several
therapeutic classes; Glaxo has a leading position in internal medicine and respiratory; SKB in
anti-infectives and internal medicine. Smaller firms such as Zeneca and Wellcome are far
more specialised; world-wide, Zeneca leads in one technology only, oncology; and Wellcome
(acquired by Glaxo in 1995) in anti-virals.
^' Using a standard t-test, it was found that within the top 10, the difference in mean market
share between 1983 and 1988 or 1992 was insignificant. However, the difference was
significant at the 1% level when comparing 1983 (or 1988) and 1995, and this was also true at
the 10% level when comparing 1992 and 1995. The same significance pattern is observed
within the Top 20.
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CATHERINE MATRAVES
expect prices to tend to marginal cost as the number of firms become very
large in this segment of the market.'"
In the context of this case, the alternative hypothesis is that the
pharmaceutical industry is a Type 2 high-a rather than low-a industry. The
arguments put forward in Section II concerning the nature of the
technology indicate this is unlikely. If this industry were a Type 2 high-a
industry, the expectation would be that given the observed increase in
advertising and R&D expenditure, combined with tougher price competition, the pharmaceutical industry would become extremely
concentrated, with the new technology of rational drug design displacing
the old. This is not what is being observed. The evidence on concentration
indicates that although the industry is becoming more consolidated, the
two leading firms still only have a global market share of around 4.5%.
This is a high level of fragmentation in an industry characterised by two
types of endogenous sunk costs, and is due to the proliferation mechanism
at work, rather than the escalation mechanism. Only in the OTC market
would we expect the escalation mechanism to dominate and concentration
to be correspondingly higher.
V.
191
Cardiovascular:
Respiratory system:
Anti-infectives:
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Pain Control:
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